When it comes to trusts, most people are familiar with individual trusts, trust funds or family trusts that are connected to an individual or family. But another type of trust exists for entrepreneurs and companies called business trusts, which are also known as common law trusts. A business trust is a legal instrument that can be used to delegate the authority to manage a beneficiary stake in a certain business. It can also be used to run the business itself. However, there are multiple types of business trusts, with each working slightly differently. If you’re thinking of using a business trust, it might be a good idea to consult with a financial advisor.
What Is a Business Trust?
Functionally, a business trust is quite similar to an individual or family trust. It helps delegate control of assets to a trustee, who manages the trust and its contents on behalf of the grantor. An individual trust typically contains assets such as money or property, but a business trust holds the rights to an individual’s stake or interest in a business. As a result, a business trust can be the legal entity that technically owns a business.
Business trusts can have one or multiple beneficiaries. A business can be owned by multiple trusts and entities or just a single one. They are primarily used to safeguard against taxes and liability, as trusts tend to have different legal protections than individuals. However, the specifics of these rules can vary by state.
How Does a Business Trust Work?
A business trust is a legal agreement. In turn, the process of creating one typically begins with a conversation between the involved parties and a trust lawyer who can help define the terms of the agreement. Following this, the trust is legally created through what is called a declaration of trust.
The declaration of trust details the terms of the trust and delegates instructions and responsibilities for the trustee. These may include the valid length of the trust and the duties, powers and interests of the beneficiaries. Once the terms are settled, the one who owns the trust signs the declaration, officially creating it in the process.
The trustee of a business trust has a fiduciary duty to act in the best interests of the beneficiaries of the trust. This is the same kind of fiduciary duty that applies to other financial situations. Most notably, SEC-registered financial advisors have a fiduciary duty to act in the best interests of their clients.
The trustee is the one who holds the rights and control of the business stake in the trust. It’s typically one individual serving as a trustee of a business trust. At the end of the trust’s length, the business interests transfer to its beneficiaries. Business trusts are treated as corporations and may conduct business transactions just like individuals.
Types of Business Trusts
Just as there are several different types of individual trusts, there are three main categories of business trusts. Here’s a breakdown of each:
The first type is called a grantor trust. Grantor trusts consist of a grantor, a trustee and a beneficiary. This type of trust is very self-contained. The grantor pays taxes on the income that comes from the trust and has complete control over it. This includes control over business distributions to the beneficiaries.
Next is a simple trust. For a trust to fall into this category, its status must be verified by the IRS. With a simple trust, the trustee must distribute business profits directly to the beneficiaries. It’s also prohibited from doing things like touching any principal assets.
A complex trust is in some ways the opposite of a simple trust, though it still isn’t managed by the beneficiaries of the trust. Business profits and other funds may be distributed only in part to beneficiaries and may even be contributed to other organizations, such as charities. In order to maintain status as a complex trust, the trust needs to have at least some form of income.
Pros and Cons of Business Trusts
There are several benefits and downsides to opening and using a business trust. The most prominent perk has to do with liability. Similar to an LLC or corporation, business trusts are created so that the beneficiaries of the trust can reap the benefits of owning and often running the business, while being protected from individual liability. Business trusts are also beneficial because they provide an added layer of privacy and it’s easy to set distribution terms for beneficiaries.
On the flip side, business trusts can be expensive and difficult to maintain. You’ll want to work with a lawyer to open a trust, but you’ll probably want to retain their services throughout the life of the trust to ensure it continues to operate the way you want it to. This process isn’t always easy, as business trusts can face a variety of obstacles when it comes to legal compliance. Additionally, business trusts typically can’t have lifetimes of longer than 99 years, so multi-generational arrangements may not be an option.
How to Set Up a Business Trust
If you’re interested in setting up a business trust, the first step is to talk to an attorney that can help. As we state above, you’ll likely need to work with an attorney throughout the life of your business trust. Note that trust lawyers typically charge around $500 per hour and the outright cost to set up a business trust could be more than $5,000.
Once the trust is up and operating, the hardest part is officially out of the way. While you may need to amend the trust down the road, you’ll have to detail some of the most important terms, such as the distribution schedules, trustees and beneficiaries.
A business trust is often difficult to set up, and it’s not a necessary part of every business out there. Your business arrangement may be good as it is, or you may be better suited to use a limited liability corporation (LLC), a partnership or another type of structure. Before you pull the trigger on creating a business trust, it’s important to figure out the key elements surrounding it.
Tips for Business Planning
Deciding how to structure your business isn’t always an easy task. It can help to have a financial advisor in your corner, guiding you through some of the toughest decisions. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors, get started now.
When deciding on a business plan, it’s important to cover all the necessary details, from future income projections to leadership hierarchies. Check out SmartAsset’s guide to writing a financial plan for a business.
Photo credit: ©iStock.com/ljubaphoto, ©iStock.com/Yagi-Studio, ©iStock.com/seb-ra